Mac-Gray Corporation (TUC) – Laundering Money

Mac-Gray (TUC) is an operator of laundry rooms in multi-unit housing facilities such as apartment buildings and colleges. They are the second largest company in the space with 86,000 rooms in 43 states.

Business Model

TUC contracts with facilities owners for the rights to manage the laundry room in their buildings. TUC supplies the coin or smart-card operated laundry machines and services the laundry room. In return, TUC pays a portion of revenues (ranging from 38%-60%) from the laundry services to the facility owner, and sometimes pays an upfront fee as well. The management contracts average seven years, after which time the parties can renegotiate the deal and typically new equipment is installed upon contract renewal. They also have a small segment (5% of revenues) that distributes laundry equipment to commercial buyers.

The business has some attractive features:

Recent History and Earnings Power

In the '05-'08 period, TUC pursued an aggressive acquisition strategy with the typical end result of overpaying and overleveraging the company. In the last four years the business has been slightly down to flat during which time management (prodded by activist shareholders) cut back on capital spending and deleveraged the balance sheet:TUC has done $66 million a year in EBITDA for the last two years. That appears to be a stable run rate for now. Where thingsget tricky is depreciation and amortization versus capex. TUC is showing $47.5 million in D&A, while cash maintenance capex on the current portfolio of facilities is around $25 million. About $13 million of the difference relates to the amortization of contracts acquired in acquisitions of competitors. The rest of the difference is caused by the accelerated depreciation on machine assets acquired in the acquisitions of 06-08, which are being depreciated over five years instead of the typical ten.

The business is still capital intensive due to the fact that equipment is typically replaced upon renewal every seven years. Capex from 08-10 was all maintenance capex, which includes equipment in renewal locations as well as in new locations to replace unrenewed contracts. Capex over that period averaged $24 million so that is probably a good proxy for maintenance capex, and is in line with management estimates of $20-25 million. (The upfront incentive fees paid to facility owners are capitalized in a separate account and amortized to cost of sales and not D&A and are thus not included in capex. The amortized amount has roughly matched the cash expense for the last few years.) So on an unlevered basis we get about $42 million in normalized pre-tax earnings (EBITDA-maintenance capex).

Cash interest is about $13 million a year at current debt levels. The normalized tax rate is 41%, and the currently high D&A serves as a nice tax shield. That gives us $26.7 million in normalized free cash flow:

As the company puts it in their investor presentation the three drivers of revenue are: number of laundry machines in the portfolio, cycles run per machine, and price of a load. All of these metrics have taken a hit over the past few years.. The company has shrunk its laundry room portfolio 1-2% in an effort to conserve capital and not renew contracts on unattractive terms. Machine utilization also declined due to increased apartment vacancies during the recession. Management estimates that has been a $15 million a year hit to revenue from normalized vacancy levels. And lastly, the company has not increased laundry prices in two years even as their operating expenses have risen. Management feels the business environment is improving and they have announced a range of initiatives to grow earnings:

Rolling out the “Change Point” electronic payment system (where the customer can pay by credit or debit card) in new or renewed accounts[/list]

Capital Allocation

The core questions for an investment in TUC are A. is this is still a good business that is worth reinvesting capital in? and B. if not, will management and the board return free cash flow to shareholders accordingly? From their history and recent comments, the answer to B is most likely no. That leaves us with the first question- will TUC be able to earn a decent return on reinvested capital? This is a mature industry with lots of competition including large national players like Coinmach and many smaller regional players. And while on the face of it TUC should have meaningful competitive advantages due to economies of scale their ROIC numbers do not reflect that:

(Assumes constant maintenance capex of $24 million. Invested capital defined as shareholder’s equity+debt-cash. Tax rate assumed at constant 41% in line with historical average). While the numbers could certainly be worse, TUC is probably not earning its cost of capital. And while one might argue that invested capital is overstated due to the overpriced acquisitions that might prove the point- the only growth TUC has been able to manage in years is overpaying to buy out competitors at a poor ROIC. That leaves the “blame it on the economy” argument for the muted recent returns. While there might be something to that argument, for investors it doesn’t really matter unless one is very bullish on the economy rebounding in the near future.

One example where the impact of competition might go unnoticed is the new Change Point system. TUC is touting this a game changer for the industry. This technology enables customers to pay for laundry machine use by credit or debit card. It also electronically monitors the laundry room so that customers can be alerted by email or text when laundry is done and property managers can get real-time reports on laundry room status. While still in the very early stages (in 750 rooms at the end of 2011) this technology has increased same facility revenues 10% over previously coin-operated rooms (which still make up 70% of the units for TUC). This system will also enable TUC to more effectively adjust pricing as it can now be changed in any increment versus only 25 cent changes in coin operated machines. Certainly, this sounds attractive. But aside from the fact that this will take a while to roll out (it can only be implemented upon renewal when machines are changed out), their larger competitor, Coinmach, has the same technology. So over time any incremental profits from the new system will probably be competed away and given back to the facility owners in the form of a larger cut of revenues.

While management has not given detailed guidance, the capital allocation is clearly shifting from the deleveraging mode of the past few years to investing more capital in the business. Part of that emphasis might stem from the TUC board’s recent rebuttal of a $17.50 a share buyout offer from a shareholder. That valued TUC equity at $250 million, or a 10.6% FCF yield (assuming the above $26.7 million in FCF). That is probably pretty close to fair value for this business if there is no growth left in it. The buyout offer prompted management to update their business plan to include more growth initiatives.

In '09 and '10, TUC reduced debt by $75 million, and they have payed down another $13 million through three quarters in '11. Management has said there will be further deleveraging, but they have not revealed a target leverage level and it sounds like they think something close to the current level of debt is sustainable if they find suitable acquisition targets. The company put in a small dividend in 2010 and recently raised it 24 cents a share, or $3.4 million, annually. They also recently announced a token $2 million stock buyback. So it sounds like most of the free cash flow in the near future will be going back into the business via the various announced growth initiatives.

Valuation

TUC trades at 9.3X EV/EBITDA-maintenance capex. On an unlevered basis TUC does not appear very cheap for a business with minimal growth prospects. It is cheaper on a levered basis at a 13.3% normalized FCF yield. It is probably fair to look at TUC on a levered basis given the stable nature of their business and their long term contracts. A 13% FCF yield could be attractive for what looks like a stable recession resistant business without risk of technological obsolescence. And there might be some embedded upside to run rate earnings with price increases, a possible rise in utilization as vacancy rates decline, and the roll out of Change Point. If the company were to commit to more aggressive return of capital to shareholders it might be an interesting opportunity. But I don’t think either the somewhat cheap valuation or the potential drivers of increased earnings are compelling enough to justify an investment in a minimal growth business without confidence in profitable capital allocation.

Disclosure: No position

Elie Rosenberg runs a value investing research website at valueslant.com. Sign up here to get his free value investing ideas and analysis by email and get his free ebook,"16 Ways to Find Undervalued Stocks."

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